Let’s face it: Large corporations have our country, and us, in a death grip. Some of their bad behavior makes big headlines: the BP oil disaster, Goldman Sachs’ financial shenanigans, Enron’s book-cooking. However, equally dangerous corporate activity happens every day, far from public view.

Corporations have seeped almost invisibly into nearly every government agency and too many congressional offices. And they’re as poisonous as carbon monoxide. In the last 20 years, protective legislation and regulation, carefully constructed from the days of President Coolidge and vastly strengthened due to the Depression, have seriously deteriorated.

There’s nothing inherently evil, or even bad, about corporations. Indeed, the combination of capital and management under one roof is efficient and essential in a global, competitive world. So much of our standard of living and our worldwide leadership are directly traceable to our corporate and entrepreneurial culture. But even good things, when they get out of control, turn destructive. Cancer, after all, is just growth gone wild.

There has always been tension between good government and free enterprise. It hurts the bottom line to scrub emissions from coal-burning power generators, ensure meat is sanitary, clean up toxic waste, and disclose the full risks of financial products. But once corporations realized that instead of fighting government they could actually buy it through lobbying and political contributions, the base of our democracy eroded. Their “invisible power” got a grip. The stealthy hunt for corporate profits metastasized from the marketplace and entered the halls of Congress and the executive branch.

The fight over reforming Wall Street is just the latest example. The need for regulation is hardly theoretical here. We’re still reeling from a crisis caused by the absence of it. Congress doesn’t even need to reinvent the wheel, a favorite task. There were laws and regulations that had worked for so long, such as those to keep banks and investment brokers separate; require diligent lending; prohibit betting against your own borrowers; require full disclosure to borrowers; and, above all, keep the risk with the lenders to insure they make prudent loans.

So why has the debate on reform dragged on for nearly a year? The public wants Wall Street reined in. So why would any legislator, much less an entire political party, get in the way of financial reform? It can’t just be a coincidence that the financial sector happens to be the biggest contributor to 2010 congressional campaigns, with more than $129 million doled out already. Financial firms have also spent well over a half a billion dollars on lobbying since early 2009.

To reverse this situation we must change who gets elected to Congress. And that is the one thing we can do, and perhaps the only thing, to neutralize corporate control of our government. Only real people have the vote; corporations don’t.

To regain our democracy, we must:

Identify and make public those elected representatives who owe their jobs to corporate largesse and cast their votes accordingly.

Insulate the election process from corporate funding. Bills in both the Senate and House that would forbid campaign spending by contractors who receive more than $50,000 in taxpayer funds would be a good start.

Prohibit lawmakers and lobbyists from interacting with each other, except to exchange ideas on legislation, and require them to publish a record of their contacts.

It may take several election cycles to scrub corporate influence and control from our political system, but once it starts it will gain momentum. And once we’ve accomplished this feat, appropriate regulation and control will follow. The horse will be before the cart, and the driver will be a human person.

While individuals, businesses and governments suffer from a credit crisis created on Wall Street, the banks responsible for the crisis are tapping into nearly-interest-free credit lines and using the money to speculate or to make commercial loans at much higher rates. By forming their own banks, states too can tap into very low interest rates, and can buffer themselves from another Lehman-style credit collapse.

Keeping interest rates low is considered the first line of defense for central banks bent on easing the credit crisis and getting banks to lend again. The Federal Reserve’s target for the federal funds rate — the overnight interest rate that banks charge each other – has been kept at a rock-bottom 0% to 0.25% ever since December 2008. A growing number of economists now think it could stay there well into 2011 or even 2012, prompted by fears that a spreading debt crisis in Europe could hurt a budding U.S. recovery.

Dirk van Dijk, writing for the investor website Zacks.com, explains what a good deal this is for the banks:

“Keeping short-term rates low . . . is particularly helpful to the big banks like Bank of America (BAC) and JPMorgan (JPM). Their raw material is short-term money, which is effectively free right now. They can borrow at 0.25% or less, and then turn around and invest those funds in, say, a 5-year T-note at 2.50%, locking in an almost risk-free profit of 2.25%. On big enough sums of money, this can be very profitable, and will help to recapitalize the banking system (provided they don’t drain capital by paying it out in dividends or frittering it away in outrageous bonuses to their top executives).”

This can be very profitable indeed for the big Wall Street banks, but the purpose of the near-zero interest rates was supposed to be to get the banks to lend again. Instead, they are investing this virtually interest-free money in risk-free government bonds, on which we the taxpayers are paying 2.5% interest; or are using the money to engage in the same sort of unregulated speculation that nearly brought down the economy in 2008, or to buy up smaller local banks, or to pay “outrageous bonuses to their top executives.” Even when banks do deign to use their nearly-interest-free funds to support loans, they do not pass these very low rates on to borrowers. The fed funds rate was lowered by 5% between August 2007 and December 2008; yet the 30 year fixed mortgage rate dropped less than 1%, from 6.75% to only about 6%.

Why Do Banks Need to Borrow? Because They Don’t Really Have the Money They Lend

Dirk van Dijk writes that “short-term money” — meaning money borrowed short-term from other banks — is the “raw material” of the big banks. Why, you may ask, do banks need to borrow from each other? Don’t they just take in money from their depositors and relend it?

“Banks actually create money when they lend it. Here’s how it works: Most of a bank’s loans are made to its own customers and are deposited in their checking accounts. Because the loan becomes a new deposit, just like a paycheck does, the bank . . . holds a small percentage of that new amount in reserve and again lends the remainder to someone else, repeating the money-creation process many times.”

A bank simply advances bank credit created on its books. This credit becomes a deposit in the account of the borrower, who can write checks on it. The checks then get deposited in other banks and trade in the economy as what we all know as “money.”

A bank can create as much money on its books as it can find creditworthy borrowers for, up to the limit of its capital requirement. The hitch comes when the checks drawn on these loans-turned-deposits are cleared, usually through the Federal Reserve. A bank with a 10% reserve requirement must keep 10% of its deposits either as “vault cash” or in a reserve account at the Fed, and when checks are cleared by the Fed, it is through this account. The effect is to make the bank short of reserves, which it can try to replenish by attracting back the customers of the bank where the credit was deposited. But as was explained by the Winterspeak blogging team:

“If bank A [the lending bank] fails to [attract new depositors], then it simply borrows the reserves it needs overnight from . . . bank B [the bank where the reserves wound up]. The overnight lending market is designed to do exactly this. Bank B, in this case, happens to have exactly the quantity of reserves bank A needs, and since reserves earn no interest, is happy to lend to bank A at the federal funds rate, which is the overnight interbank lending rate.”

In effect, a bank can create money on its books, lend the money at interest (today about 4.7% on a fixed rate mortgage), then clear the outgoing check by borrowing back the money it just created, at a cost to the bank of only the very low fed funds rate (now .2%). The bank creates bank credit, lends it at 4.7%, then borrows it back at .2% to clear the outgoing checks, collecting 4.5% interest as its profit. The credit the bank has lent is not an asset it has labored to earn but is simply “the full faith and credit of the United States” – the credit of the people collectively. Yet the bank is allowed to pocket a hefty interest spread on this credit-generating scheme; and that is assuming it lends at all, something that is happening less and less these days, since bankers find it safer and more lucrative to use their nearly interest-free credit lines to invest in risk-free government bonds at taxpayers’ expense, engage in speculation, or pay themselves sizeable bonuses.

Avoiding Another Lehman-style Credit Collapse

The reason banks are highly dependent on loans from each other, then, is that they need these low-cost loans to keep the credit shell game going. This is particularly true for large Wall Street banks. Small banks get their funds mainly from customer deposits, and usually have more deposits than they can find creditworthy borrowers for. Large banks, on the other hand, generally lack sufficient deposits to fund their main business — dealing with large companies, governments, other financial institutions, and wealthy people. Most borrow the funds they need from other major lenders in the form of short term liabilities that must be continually rolled over.

That helps shed light on what really caused the credit crisis following the collapse of Lehman Brothers in September 2008. The Lehman bankruptcy triggered a run on the money markets, causing interbank lending rates to soar. The London interbank lending rate (LIBOR) normally adheres closely to official interest rate expectations (meaning, in the U.S., the targeted fed funds rate); but after Lehman went bankrupt, the LIBOR rate for short-term loans shot up to around 5%. Since the cost of borrowing the money to cover their loans was too high for banks to turn a profit, lending abruptly came to a halt.

Interest rates on variable rate mortgages and big corporate deals tend to be based on LIBOR rates, which are moving up again now, although the fed funds rate has not changed. LIBOR rates are moving up due to tensions arising from the possibility that Europe’s sovereign debt crisis could turn into another global banking crisis.

This is just one of many reasons that states should consider following the model of North Dakota, the only state that currently owns its own bank. The state-owned Bank of North Dakota (BND) helped North Dakota escape the credit crisis. The BND has a very large and captive deposit base, since all of the revenues of the state are deposited in the bank by law, keeping the bank solvent regardless of what is happening in the interbank lending market. North Dakota is currently the only state not struggling with a budget deficit.

Nations could follow this model as well. A recent article in The Economist noted that the strong and stable publicly-owned banks of India, China and Brazil helped those countries weather the banking crisis afflicting most of the world in the last two years.

If You Can’t Beat Them, Join Them

While the banks responsible for today’s economic crisis are enjoying unprecedented benefits, state and local governments are forced to maintain very large and wasteful rainy day funds, even as they are slashing services to balance their budgets. They have to do this because they do not have the secure, nearly-interest-free credit lines available to private banks. Owning their own banks can allow local governments to avail themselves of the very low interest rates accessible to private banks, by giving them the same authority to create “bank credit” on their books that private banks have. North Dakota, which has had its own government-owned bank for over 90 years, not only is the only state to sport a budget surplus but has the lowest unemployment rate in the U.S. It evidently has no funding problems at all. Five other states currently have bills on their books to consider forming their own banks, and several others have discussed that option in their legislatures.

The Federal Reserve and the U.S. government have gone to extraordinary lengths to keep a corrupt banking system afloat, including buying toxic assets off their books and making credit available nearly interest-free, all in the name of turning the credit spigots back on on Main Street; but the banks have not kept their end of the bargain. In fact, they are just doing what their business models require of them – making the highest possible return for their shareholders. Publicly-owned banks operate on a different model: they must serve the community. Like China, India and Brazil, U.S. states would be well served to set up publicly-owned banks that could provide credit to the local economy when the private banking scheme fails.

Ellen Brown developed her research skills as an attorney practicing civil litigation in Los Angeles. In Web of Debt, her latest of eleven books, she turns those skills to an analysis of the Federal Reserve and “the money trust.” She shows how this private cartel has usurped the power to create money from the people themselves, and how we the people can get it back. Her websites are www.webofdebt.com, www.ellenbrown.com, and www.public-banking.com.

It’s early May in Washington, and something very weird is in the air. As Chris Dodd, Harry Reid and the rest of the compulsive dealmakers in the Senate barrel toward the finish line of the Restoring American Financial Stability Act – the massive, year-in-the-making effort to clean up the Wall Street crime swamp – word starts to spread on Capitol Hill that somebody forgot to kill the important reforms in the bill. As of the first week in May, the legislation still contains aggressive measures that could cost once-
indomitable behemoths like Goldman Sachs and JP Morgan Chase tens of billions of dollars. Somehow, the bill has escaped the usual Senate-whorehouse orgy of mutual back-scratching, fine-print compromises and freeway-wide loopholes that screw any chance of meaningful change.

The real shocker is a thing known among Senate insiders as “716.” This section of an amendment would force America’s banking giants to either forgo their access to the public teat they receive through the Federal Reserve’s discount window, or give up the insanely risky, casino-style bets they’ve been making on derivatives. That means no more pawning off predatory interest-rate swaps on suckers in Greece, no more gathering balls of subprime shit into incomprehensible debt deals, no more getting idiot bookies like AIG to wrap the crappy mortgages in phony insurance. In short, 716 would take a chain saw to one of Wall Street’s most lucrative profit centers: Five of America’s biggest banks (Goldman, JP Morgan, Bank of America, Morgan Stanley and Citigroup) raked in some $30 billion in over-the-counter derivatives last year. By some estimates, more than half of JP Morgan’s trading revenue between 2006 and 2008 came from such derivatives. If 716 goes through, it would be a veritable Hiroshima to the era of greed.

“When I first heard about 716, I thought, ‘This is never gonna fly,'” says Adam White, a derivatives expert who has been among the most vocal advocates for reform. When I speak to him early in May, he sounds slightly befuddled, like he can’t believe his good fortune. “It’s funny,” he says. “We keep waiting for the watering-down to take place – but we keep getting to the next hurdle, and it’s still staying strong.”

In the weeks leading up to the vote on the reform bill, I hear one variation or another on this same theme from Senate insiders: that the usual process of chipping away at key legislation is not taking place with its customary dispatch, despite a full-court press by Wall Street. The financial-services industry has reportedly flooded the Capitol with more than 2,000 paid lobbyists; even veteran members are stunned by the intensity of the blitz. “They’re trying everything,” says Sen. Sherrod Brown, a Democrat from Ohio. Wall Street’s army is especially imposing given that the main (really, the only) progressive coalition working the other side of the aisle, Americans for Financial Reform, has been in existence less than a year – and has just 60 unpaid “volunteer” lobbyists working the Senate halls.

The companies with the most at stake are particularly well-connected. The lobbying campaign for Goldman Sachs, for instance, is being headed up by a former top staffer for Rep. Barney Frank, Michael Paese, who is coordinating some 14 different lobbying firms to fight on Goldman’s behalf. The bank is also represented by Capitol Hill heavyweights like former House majority leader Dick Gephardt and former Reagan chief of staff Ken Duberstein. All told, there are at least 40 ex-staffers of the Senate Banking Committee – and even one former senator, Trent Lott – lobbying on behalf of Wall Street. Until the final weeks of the reform debate, however, it seemed that all these insiders were facing the prospect of a rare defeat – and they weren’t pleased. One lobbyist even complained to The Washington Post that the bill was being debated out in the open, on the Senate floor, instead of in a smoky backroom. “They’ve got to get this thing off the floor and into a reasonable, behind-the-scenes” discussion, he groused. “Let’s have a few wise fathers sit around the table in some quiet room” to work it out.

As it neared the finish line, the Restoring American Financial Stability Act was almost unprecedentedly broad in scope, in some ways surpassing even the health care bill in size and societal impact. It would rein in $600 trillion in derivatives, create a giant new federal agency to protect financial consumers, open up the books of the Federal Reserve for the first time in history and perhaps even break up the so-called “Too Big to Fail” giants on Wall Street. The recent history of the U.S. Congress suggests that it was almost a given that they would fuck up this one real shot at slaying the dragon of corruption that has been slowly devouring not just our economy but our whole way of life over the past 20 years. Yet with just weeks left in the nearly year-long process at hammering out this huge new law, the bad guys were still on the run. Even the senators themselves seemed surprised at what assholes they weren’t being. This new baby of theirs, finance reform, was going to be that one rare kid who made it out of the filth and the crime of the hood for everybody to be proud of.

Then reality set in.

Picture the Restoring American Financial Stability Act as a vast conflict being fought on multiple fronts, with the tiny but enormously influential Wall Street lobby on one side and pretty much everyone else on the planet on the other. To be precise, think World War II – with some battles won by long marches and brutal campaigns of attrition, others by blitzkrieg attacks, still more decided by espionage and clandestine movements. Time after time, at the last moment, the Wall Street axis has turned seemingly lost positions into surprise victories or, at worst, bitterly fought stalemates. The only way to accurately convey the scale of Wall Street’s ingenious comeback is to sketch out all the crazy, last-minute shifts on each of the war’s four major fronts.

Naked short selling

From Wikipedia, the free encyclopedia

Schematic representation of naked short selling in two steps. The short seller sells shares without owning them. He then purchases and delivers the shares for a different market price. If the short seller cannot afford the shares in the second step, or the shares are not available, a “fail to deliver” results.

Naked short selling, or naked shorting, is the practice of short-selling a financial instrument without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale. When the seller does not obtain the shares within the required time frame, the result is known as a “fail to deliver”. The transaction generally remains open until the shares are acquired by the seller, or the seller’s broker, allowing the trade to be settled.[1] Naked short selling can be used to fraudulently manipulate the price of securities by driving their price down, and its use in this way is illegal.[2]

In the United States, naked short selling is covered by various SEC regulations which prohibit the practice.[3] In 2005, “Regulation SHO” was enacted, requiring that broker-dealers have grounds to believe that shares will be available for a given stock transaction, and requiring that delivery take place within a limited time period.[4][5] As part of its response to the crisis in the North American markets in 2008, the SEC issued a temporary order restricting short-selling in the shares of 19 financial firms deemed systemically important, by reinforcing the penalties for failing to deliver the shares in time.[6] Effective September 18, 2008, amid claims that aggressive short selling had played a role in the failure of financial giant Lehman Brothers, the SEC extended and expanded the rules to remove exceptions and to cover all companies, including market makers.[7][8][9]

Some commentators have contended that despite regulations, naked shorting is widespread and that the SEC regulations are poorly enforced. Its critics have contended that the practice is susceptible to abuse, can be damaging to targeted companies struggling to raise capital, and has led to numerous bankruptcies.[3][7][10] However, other commentators have said that the naked shorting issue is a “devil theory”,[11] not a bona fide market issue and a waste of regulatory resources.[12]

Description

Normal shorting

Short selling is a a form of speculation that allows a trader to take a “negative position” in a stock of a company. Such a trader first “borrows” shares of that stock from their owner (the lender), typically via a bank or a prime broker under the condition that he will return it on demand. Next, the trader sells the borrowed shares and delivers them to the buyer who becomes their new owner. The buyer is typically unaware that the shares have been sold short: his transaction with the trader proceeds just as if the trader owned rather than borrowed the shares. Some time later, the trader closes his short position by purchasing the same number of shares in the market and returning them to the lender.

The trader’s profit is the difference between the sale price and the purchase price of the shares. In contrast to “going long,” where sale succeeds the purchase, short sale precedes the purchase. Because the seller/borrower is generally required to make a cash deposit equivalent to the sale proceeds, it offers the lender some security.

Naked shorts in the United States

Naked short selling is a case of short selling without first arranging a borrow. If the stock is in short supply, finding shares to borrow can be difficult. The seller may also decide not to borrow the shares, in some cases because lenders are not available, or because of the costs of lending. When shares are not borrowed within the clearing time period and the short-seller does not tender shares to the buyer, the trade is considered to have “failed to deliver.”[13] Nevertheless, the trade will continue to sit open or the buyer may be credited the shares by the DTCC until either the short-seller closes out the position or borrows the shares.[2]

It is difficult to measure how often naked short selling occurs. Fails to deliver are not necessarily indicative of naked shorting, and can result from both “long” transactions (stock purchases) and short sales.[4][14] Naked shorting can be invisible in a liquid market, as long as the short sale is eventually delivered to the buyer. However, if the covers are impossible to find, the trades fail. Fail reports are published regularly by the SEC[15], and a sudden rise in the number of fails-to-deliver will alert the SEC to the possibility of naked short selling. In some recent cases, it was claimed that the daily activity was larger than all of the available shares, which would normally be unlikely.[13]

Extent of naked shorting

The reasons for naked shorting, and the extent of it, have been disputed for several years before the SEC’s 2008 action to prohibit the practice. What is generally recognized is that naked shorting tends to happen when shares are difficult to borrow. Studies have shown that naked short selling also increases with the cost of borrowing.

In recent years, a number of companies have been accused of using naked shorts in aggressive efforts to drive down share prices, sometimes with no intention of ever delivering the shares.[13][16] These claims focus on the fact that, at least in theory, the practice allows an unlimited number of shares to be sold short. A Los Angeles Times editorial in July 2008 said that naked short selling “enables speculators to drive down a company’s stock by offering an overwhelming number of shares for sale.”[17] The SEC has stated that naked shorting is sometimes falsely asserted as a reason for a share price decline, when, often, “the price decrease is a result of the company’s poor financial situation rather than the reasons provided by the insiders or promoters.”[4]

Before 2008, regulators had generally downplayed the extent of naked shorting in the US. At a North American Securities Administrators Association (NASAA) conference on naked short selling in November 2005, an official of the New York Stock Exchange stated that NYSE had not found evidence of widespread naked short selling. In 2006, an official of the SEC said that “While there may be instances of abusive short selling, 99% of all trades in dollar value settle on time without incident.”[18] Of all those that do not, 85% are resolved within 10 business days and 90% within 20.[18] That means that about 1% of shares that change hands daily, or about $1 billion per day, are subject to delivery failures,[2] although the SEC has stated that “fails-to-deliver can occur for a number of reasons on both long and short sales,” and accordingly that they do not necessarily indicate naked short selling.[4][14]

In 2008, SEC chairman Christopher Cox said that the SEC “has zero tolerance for abusive naked short-selling” while implementing new regulations to prohibit the practice, culminating in the September 2008 action following the failures of Bear Sterns and Lehman Brothers amidst speculation that naked short selling had played a contributory role.[8][19] Cox said that “the rule would be designed to ensure transparency in short-selling in general, beyond the practice of naked short-selling.”[8]

Claimed effects of naked shorting

As with the prevalence of naked shorting, the effects are contested. The SEC has stated that the practice can be beneficial in enhancing liquidity in difficult-to-borrow shares, while others have suggested that it adds efficiency to the securities lending market. Critics of the practice argue that it is often used for market manipulation, that it can damage companies and even that it threatens the broader markets.

One complaint about naked shorting from targeted companies is that the practice dilutes a company’s shares for as long as unsettled short sales sit open on the books. This has been alleged to create “phantom” or “counterfeit” shares, sometimes going from trade to trade without connection to any physical shares, and artificially depressing the share price.[16] However, the SEC has disclaimed the existence of counterfeit shares and stated that naked short selling would not increase a company’s outstanding shares.[5] Short seller David Rocker contended that failure to deliver securities “can be done for manipulative purposes to create the impression that the stock is a tight borrow,” although he said that this should be seen as a failure to deliver “longs” rather than “shorts.”[20]

Robert J. Shapiro, former undersecretary of commerce for economic affairs, and a consultant to a law firm suing over naked shorting,[21] has claimed that naked short selling has cost investors $100 billion and driven 1,000 companies into the ground.[10]

Richard Fuld, the former CEO of the financial firm Lehman Brothers, during hearings on the bankruptcy filing by Lehman Brothers and bailout of AIG before the House Committee on Oversight and Government Reform alleged that a host of factors including a crisis of confidence and naked short selling attacks followed by false rumors contributed to both the collapse of Bear Stearns and Lehman Brothers.[22] Fuld had been obsessed with short sellers and had even demoted those Lehman executives that dealt with them; he claimed that the short sellers and the rumour mongers had brought down Lehman, although he hadn’t evidence of it.[23] Upon the examination of the issue of whether “naked short selling” was in any way a cause of the collapse of Bear Stearns or Lehman, securities experts reached the conclusion that the alleged “naked short sales” occurred after the collapse and therefore played no role in the collapse. House committee Chairman Henry Waxman said the committee received thousands of pages of internal documents from Lehman and these documents portray a company in which there was “no accountability for failure”.[24][23][25] In July 2008, U.S. Securities and Exchange Commission chairman Christopher Cox said there was no “unbridled naked short selling in financial issues.”[26]

Regulations in the United States

Securities Exchange Act of 1934

The Securities Exchange Act of 1934 stipulates a settlement period up to three business days before a stock needs to be delivered,[13] generally referred to as “T+3 delivery.”

Regulation SHO

The SEC enacted Regulation SHO in January 2005 to target abusive naked short selling by reducing failure to deliver securities, and by limiting the time in which a broker can permit failures to deliver.[27] In addressing the first, it stated that a broker or dealer may not accept a short sale order without having first borrowed or identified the stock being sold.[28] The rule had the following exemptions:

Broker or dealer accepting a short sale order from another registered broker or dealer

Broker-dealer effecting a sale on behalf of a customer that is deemed to own the security pursuant to Rule 200[29] through no fault of the customer or the broker-dealer.[28]

To reduce the duration for which fails to deliver are permitted to sit open, the regulation requires broker-dealers to close-out open fail-to-deliver positions in threshold securities that have persisted for 13 consecutive settlement days.[27] The SEC, in describing Regulation SHO, stated that failures to deliver shares that persist for an extended period of time “may result in large delivery obligations where stock settlement occurs.”[27]

Regulation SHO also created the “Threshold Security List,” which reported any stock where more than 0.5% of a company’s total outstanding shares failed delivery for five consecutive days. A number of companies have appeared on the list, including Krispy Kreme, Martha Stewart Omnimedia and Delta Airlines. The Motley Fool, an investment website, observes that “when a stock appears on this list, it is like a red flag waving, stating ‘something is wrong here!'”[13] However, the SEC clarified that appearance on the threshold list “does not necessarily mean that there has been abusive naked short selling or any impermissible trading in the stock.”[27]

In July 2006, the SEC proposed to amend Regulation SHO, to further reduce failures to deliver securities.[30] SEC Chairman Christopher Cox referred to “the serious problem of abusive naked short sales, which can be used as a tool to drive down a company’s stock price.” and that the SEC is “concerned about the persistent failures to deliver in the market for some securities that may be due to loopholes in Regulation SHO.[31]

Developments, 2007 to the present

In March 2007, the Securities and Exchange Board of India (SEBI), which disallowed short sales altogether in 2001 as a result of the Ketan Parekh affair, reintroduced short selling under regulations similar to those developed in the United States. In conjunction with this rule change, SEBI outlawed all naked short selling.[32][33]

In June 2007, the SEC voted to remove the grandfather provision that allowed fails-to-deliver that existed before Reg SHO to be exempt from Reg SHO. SEC Chairman Christopher Cox called naked short selling “a fraud that the commission is bound to prevent and to punish.” The SEC also said it was considering removing an exemption from the rule for options market makers.[34] Removal of the grandfather provision and naked shorting restrictions generally have been endorsed by the U.S. Chamber of Commerce.[35]

In March 2008, SEC Chairman Christopher Cox gave a speech entitled the “‘Naked’ Short Selling Anti-Fraud Rule,” in which he announced new SEC efforts to combat naked short selling.[36] Under the proposal, the SEC would create an antifraud rule targeting those who knowingly deceive brokers about having located securities before engaging in short sales, and who fail to deliver the securities by the delivery date. Cox said the proposal would address concerns about short-selling abuses, particularly in the market for small-cap stocks. Even with the regulation in place, the SEC received hundreds of complaints in 2007 about alleged abuses involving short sales. The SEC estimated that about 1% of shares that changed hands daily, about $1 billion, were subject to delivery failures. SEC Commissioners Paul Atkins and Kathleen Casey expressed support for the crackdown.[37][38]

In mid-July 2008, the SEC announced emergency actions to limit the naked short selling of government sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, in an effort to limit market volatility of financial stocks.[39] But even with respect to those stocks the SEC soon thereafter announced there would be an exception with regard to market makers.[40] SEC Chairman Cox noted that the emergency order was “not a response to unbridled naked short selling in financial issues”, saying that “that has not occurred”. Cox said, “rather it is intended as a preventative step to help restore market confidence at a time when it is sorely needed.”[26] Analysts warned of the potential for the creation of price bubbles.[40][41]

The emergency actions rule expired August 12, 2008.[42][43][44][45] However, at September 17, 2008, the SEC issued new, more extensive rules against naked shorting, making “it crystal clear that the SEC has zero tolerance for abusive naked short selling”. Among the new rules is that market makers are no longer given an exception. As a result, options market makers will be treated in the same way as all other market participants, and effectively will be banned from naked short selling.[46]

On November 4, 2008, voters in South Dakota considered a ballot initiative, “The South Dakota Small Investor Protection Act”, to end naked short selling in that state. The Securities Industry and Financial Markets Association of Washington and New York said they would take legal action if the measure passed.[47] The voters defeated the initiative.[48]

In July 2009, the SEC, under what the Wall Street Journal described as “intense political pressure,” made permanent an interim rule that obliges brokerages to promptly buy or borrow securities when executing a short sale.[49] The SEC said that since the fall of 2008, abusive naked short selling had been reduced by 50%, and the number of threshold list securities (equity securities with too many “fails to deliver”) declined from 582 in July 2008 to 63 in March 2009.[50][51]

Japan’s naked shorting ban started on November 4, 2008, and was originally scheduled to run until July 2009, but was extended through October of that year.[58][59] Japan’s FinanceMinister, Shōichi Nakagawa stated, “We decided (to move up the short-selling ban) as we thought it could be dangerous for the Tokyo stock market if we do not take action immediately.” Nakagawa added that Japan’s Financial Services Agency would be teaming with the Securities and Exchange Surveillance Commission and Tokyo Stock Exchange to investigate past violations of Japanese regulations on stock short-selling.[60]

The Singapore Exchange started to penalize naked short sales with an interim measure in September, 2008. These initial penalties started at $100 per day. In November, they announced plans to increase the fines for failing to complete trades. The new penalties would penalize traders who fail to cover their positions, starting at $1,000 per day. There would also be fines for brokerages who fail to use the exchange’s buying-in market to cover their positions, starting at $5,000 per day. The Singapore exchange had stated that the failure to deliver shares inherent in naked short sales threatened market orderliness.[61]

On May 18th, 2010, the German Minister of Finance announced that naked short sales of euro-denominated government bonds, credit default swaps based on those bonds, and shares in Germany’s ten leading financial institutions will be prohibited. This ban went into effect that night and is set to expire on March 31, 2011. [62][63] One week after these new restrictions were announced, it was revealed the Germany’s Finance Ministry was circulating draft proposals to extend the ban on naked short sales to cover all stocks listed in Germany. [64]

Regulatory enforcement actions

In 2005, the SEC notified Refco of intent to file an enforcement action against the securities unit of Refco for securities trading violations concerning the shorting of Sedona stock. The SEC sought information related to two former Refco brokers who handled the account of a client, Amro International, which shorted Sedona’s stock.[65] No charges had been filed by 2007.

In December 2006, the SEC sued Gryphon Partners, a hedge fund, for insider trading and naked short-selling involving PIPEs in the unregistered stock of 35 companies. PIPEs are “private investments in public equities,” used by companies to raise cash. The naked shorting took place in Canada, where it was legal at the time. Gryphon denied the charges.[66]

In March 2007, Goldman Sachs was fined $2 million by the SEC for allowing customers to illegally sell shares short prior to secondary public offerings. Naked short-selling was allegedly used by the Goldman clients. The SEC charged Goldman with failing to ensure those clients had ownership of the shares. SEC Chairman Cox said “That is an important case and it reflects our interest in this area.”[67]

In July 2007, Piper Jaffray was fined $150,000 by the New York Stock Exchange (NYSE). Piper violated securities trading rules from January through May 2005, selling shares without borrowing them, and also failing to “cover short sales in a timely manner”, according to the NYSE.[68] At the time of this fine, the NYSE had levied over $1.9 million in fines for naked short sales over seven regulatory actions.[69]

Also in July 2007, the American Stock Exchange fined two options market makers for violations of Regulation SHO. SBA Trading was sanctioned for $5 million, and ALA Trading was fined $3 million, which included disgorgement of profits. Both firms and their principals were suspended from association with the exchange for five years. The exchange said the firms used an exemption to Reg. SHO for options market makers to “impermissibly engage in naked short selling.”[70][71][72]

In October 2007, the SEC settled charges against New York hedge fund adviser Sandell Asset Management Corp. and three executives of the firm for, among other things, shorting stock without locating shares to borrow. Fines totalling $8 million were imposed, and the firm neither admitted nor denied the charges.[73]

In October 2008 Lehman Brothers Inc. was fined $250,000 by the Financial Industry Regulatory Authority (FINRA) for failing to properly document the ownership of short sales as they occurred, and for failing to annotate an affirmative declaration that shares would be available by the settlement date.[74]

There is no dispute that illegal naked shorting happens,[2][76] what is in dispute is how much it happens, and to what extent is DTCC to blame.[2][77] Some companies with falling stocks blame DTCC as the keeper of the system where it happens, and say DTCC turns a blind eye to the problem.[2] Referring to trades that remain unsettled, DTCC’s chief spokesman Stuart Goldstein said, “We’re not saying there is no problem, but to suggest the sky is falling might be a bit overdone.”[78][79] In July 2007, Senator Bennett suggested on the U.S. Senate floor that the allegations involving DTCC and naked short selling are “serious enough” that there should be a hearing on them with DTCC officials by the Senate Banking Committee, and that banking committee chairman Christopher Dodd has expressed a willingness to hold such a hearing.[80]

Critics also contend DTCC has been too secretive with information about where naked shorting is taking place.[2] Ten suits concerning naked short-selling filed against the DTCC were withdrawn or dismissed by May 2005.[81]

A suit by Electronic Trading Group, naming major Wall Street brokerages, was filed in April 2006 and dismissed in December 2007.[82][83]

Two separate lawsuits, filed in 2006 and 2007 by NovaStar Financial, Inc. shareholders and Overstock.com, named as defendants ten Wall Street prime brokers. They claimed a scheme to manipulate the companies’ stock by allowing naked short selling.[84] A motion to dismiss the Overstock suit was denied in July 2007.[85][86]

A suit against DTCC by Pet Quarters Inc. was dismissed by a federal court in Arkansas, and upheld by the Eighth Circuit Court of Appeals in March 2009.[87] Pet Quarters alleged the Depository Trust & Clearing Corp.’s stock-borrow program resulted in the creation of nonexistent or phantom stock and contributed to the illegal short selling of the company’s shares. The court ruled: “In short, all the damages that Pet Quarters claims to have suffered stem from activities performed or statements made by the defendants in conformity with the program’s Commission approved rules. We conclude that the district court did not err in dismissing the complaint on the basis of preemption.” Pet Quarters’ complaint was almost identical to suits against DTCC brought by Whistler Investments Inc. and Nanopierce Technologies Inc. The suits also challenged DTCC’s stock-borrow program, and were dismissed.[88]

Studies

A study of trading in initial public offerings by two SEC staff economists, published in April 2007, found that excessive numbers of fails to deliver were not correlated with naked short selling. The authors of the study said that while the findings in the paper specifically concern IPO trading, “The results presented in this paper also inform a public debate surrounding the role of short selling and fails to deliver in price formation.”[89]

In contrast, a study by Leslie Boni in 2004 found correlation between “strategic delivery failures” and the cost of borrowing shares. The paper, which looked at a “unique dataset of the entire cross-section of U.S. equities,” credited the initial recognition of strategic delivery fails to Richard Evans, Chris Geczy, David Musto and Adam Reed, and found its review to provide evidence consistent with their hypothesis that “market makers strategically fail to deliver shares when borrowing costs are high.”

An April 2007 study conducted for Canadian market regulators by Market Regulation Services Inc. found that fails to deliver securities were not a significant problem on the Canadian market, that “less than 6% of fails resulting from the sale of a security involved short sales” and that “fails involving short sales are projected to account for only 0.07% of total short sales.”[90][91]

A Government Accountability Office study, released in June 2009, found that recent SEC rules had apparently reduced abusive short selling, but that the SEC needed to give clearer guidance to the brokerage industry.[92]

Media Coverage

Some journalists have expressed concern about naked short selling, while others contend that naked short selling is not harmful and that its prevalence has been exaggerated by corporate officials seeking to blame external forces for internal problems with their companies.[93] Others have discussed naked short selling as a confusing or bizarre form of trading.[16][94]

In June 2007, executives of Universal Express, which had claimed naked shorting of its stock, were sanctioned by a federal court judge for violation of securities laws. [95] Referring to a court ruling against CEO Richard Altomare, New York Times columnist Floyd Norris said: “In Altomare’s view, the issues that bothered the judge are irrelevant. Long and short of it, this is a naked short hallmark case in the making. Or it is proof that it can take a long time for the SEC to stop a fraud.”[96] Universal Express claimed that 6,000 small companies had been put out of business by naked shorting, which the company said “the SEC has ignored and condoned.”[97]

Reviewing the SEC’s July 2008 emergency order, Barron’s said in an editorial: “Rather than fixing any of the real problems with the agency and its mission, Cox and his fellow commissioners waved a newspaper and swatted the imaginary fly of naked short-selling. It made a big noise, but there’s no dead bug.”[12] Holman Jenkins of the Wall Street Journal said the order was “an exercise in symbolic confidence-building” and that naked shorting involved technical concerns except for subscribers to a “devil theory”.[11]The Economist said the SEC had “picked the wrong target”, mentioning a study by Arturo Bris of the Swiss International Institute for Management Development who found that trading in the 19 financial stocks became less efficient.[98] The Washington Post expressed approval of the SEC’s decision to address a “frenetic shadow world of postponed promises, borrowed time, obscured paperwork and nail-biting price-watching, usually compressed into a few high-tension days swirling around the decline of a company.”[99] The Los Angeles Times called the practice of naked short selling “hard to defend,” and stated that it was past time the SEC became active in addressing market manipulation.[100]

The Wall Street Journal said in an editorial in July 2008 that “the Beltway is shooting the messenger by questioning the price-setting mechanisms for barrels of oil and shares of stock.” But it said the emergency order to bar naked short selling “won’t do much harm,” and said “Critics might say it’s a solution to a nonproblem, but the SEC doesn’t claim to be solving a problem. The Commission’s move is intended to prevent even the possibility that an unscrupulous short seller could drive down the shares of a financial firm with a flood of sell orders that aren’t backed by an actual ability to deliver the shares to buyers.”[101]

The Washington Post’s Frank Ahrens described naked shorting as “far more dangerous than sexy” in a July, 2008 article. “It’s a frenetic shadow world of postponed promises, borrowed time, obscured paperwork and nail-biting price-watching, usually compressed into a few high-tension days swirling around the decline of a company,” Ahrens says.[102]

In May 2009, the New York Times’s chief financial correspondent Floyd Norris reported that naked shorting is “almost gone.” He said that delivery failures, where they occur, are quickly corrected.[103]

In an article published in October 2009, Rolling Stone writer Matt Taibbi contended that Bear Stearns and Lehman Brothers were flooded with “counterfeit stock” that helped kill both companies. Taibbi said that the two firms got a “push” into extinction from “a flat-out counterfeiting scheme called naked short-selling”.[104]

During a discussion on the inclusion of ‘counterfeiting’ in the charges filed against Icelandic bankers, the host Max Keiser speculated that the charge might refer to naked short selling because “naked short-selling is the same as counterfeiting, in that it is selling something that doesn’t exist.”[105]